the sarbanes-oxley act: is the investing public really any

Volume 33 Issue 3 Summer 2003

Summer 2003

The Sarbanes-Oxley Act: Is the Investing Public Really Any Better The Sarbanes-Oxley Act: Is the Investing Public Really Any Better

Off Off

Emily Williams

Recommended Citation Recommended Citation Emily Williams, The Sarbanes-Oxley Act: Is the Investing Public Really Any Better Off, 33 N.M. L. Rev. 481 (2003). Available at: https://digitalrepository.unm.edu/nmlr/vol33/iss3/7

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THE SARBANES-OXLEY ACT: IS THE INVESTING PUBLICREALLY ANY BETTER OFF?

EMILY WILLIAMS*

I. INTRODUCTIONOn July 30, 2002, President Bush signed legislation intended to address the

corporate accounting issues that arose in the corporate scandals of late 2001 and2002.' The Sarbanes-Oxley Act, designed to "protect investors by improving theaccuracy and reliability of corporate disclosures made pursuant to securities law,"2

passed Congress in the wake of the Enron bankruptcy and other corporateaccounting scandals.3 The Act attempts to address a number of the issues related topublicly traded corporations by creating a new federal oversight agency,4establishing auditor independence rules,5 creating new laws to address corporateresponsibility,6 enhancing financial disclosure requirements,7 addressing analystconflicts of interest,' creating new corporate and criminal fraud laws,9 and enhancingpenalties for white collar crime.'°

One of the key ways the Sarbanes-Oxley Act attempts to protect investors andrestore confidence is by addressing corporate accounting issues." The Act createsa new federal agency to oversee accounting firms that perform audits, the PublicCompany Accounting Oversight Board (PCAOB).2 The Act also establishes newrules and procedures for auditors 3 and issuers.'4 This comment analyzes theprovisions of the Sarbanes-Oxley Act that attempt to improve corporate accountingand examines how the Act fits into the already complicated statutory and regulatoryscheme designed to protect and inform the investing public.

* Class of 2004, University of New Mexico School of Law.1. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-.204, 116 Stat. 745 (codified as amended in scattered

sections of 15 U.S.C. and 18 U.S.C.).2. Id. The full title of the Sarbanes-Oxley Act is "An Act to protect investors by improving the accuracy

and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes."3. Bill Carlino, The Waiting Game: Profession Begins Weighing Impact of Fraud Legislation; Sarbanes-

Oxley Act, ACCT. TODAY, Aug. 19, 2002, at 1.4. Sarbanes-Oxley Act §§ 101-109.5. Id. §§ 201-209.6. Id. §§ 301-308.7. Id. §§ 401-409.8. Id. § 501.9. Id. §§ 801-807, 1101-1107.

10. Id. §§ 901-906.11. Mike Allen, Bush Signs Corporate Reforms into Law; President Says Era of "False Profits" Is Over,

WASH. POST, July 31, 2002, at A4; President Signs Sweeping Corporate Reform Bill into Law, DEL. CORP. LITIG.REP., Aug. 19, 2002, vol. 17, no. I, at 10; Susan Cornwell, Corporate America Having Tough Time in Capital ThisYear; Congress Passes Accounting Crackdown but Leaves Bankruptcy, Terrorism Bills in Limbo, L.A. TIMES, Oct.21, 2002, pt. 3, at 6.

12. Sarbanes-Oxley Act § 101(a). See infra part W.A.13. Sarbanes-Oxley Act §§ 201-209. See infra part IV.C.14. Sarbanes-Oxley Act §§ 301-409. See infra part I.E.

The term "issuer" means an issuer (as defined in section 3 of the Securities Exchange Act (15U.S.C. 78(c))), the securities of which are registered under section 12 of that Act (15 U.S.C.78(l)), or that is required to file reports under section 15(d) (15 U.S.C. 78(o)(d)), or that files orhas filed a registration statement that has not yet become effective under the Securities Act of1933 (15 U.S.C. 77(a), et seq.), and that it has not withdrawn.

Sarbanes-Oxley Act § 2(a)(7).

NEW MEXICO LAW REVIEW

This comment argues that, although the Sarbanes-Oxley Act is a noteworthyattempt at accounting reform, it is largely a compilation of mild reforms, many ofwhich previously existed as Securities Exchange Commission (SEC) rules. Whilethe Act contains a few valuable provisions, the legislation's bark is much greaterthan its bite. Furthermore, the legislation leaves to the resource-strapped SEC andthe newly formed PCAOB the duty to enforce and monitor the majority of theprovisions.

II. BACKGROUND

A. The Securities Act of 1933

The Securities Act of 1933 (Securities Act) 5 was Congress's first attempt toregulate securities. 6 It was part of Franklin Roosevelt's New Deal legislation,passed in response to the stock market crash of 1929.1" A major goal of thelegislation was to provide full, accurate disclosure to the investing public. 8 TheSecurities Act required companies to register any securities with the SecuritiesDivision of the Federal Trade Commission prior to selling or offering the securitiesfor sale. 9 The Securities Act also created civil liabilities for misstatements oromissions of material facts by the corporation, the directors, the officers, theunderwriters, and experts such as accountants.20

B. The Securities Exchange Act of 1934In 1934, Congress enacted the Securities Exchange Act of 1934 (Exchange Act).2'

The Exchange Act created the Securities and Exchange Commission, anindependent federal agency responsible for registering and regulating nationalsecurity exchanges.22 The Exchange Act requires issuers of securities to register witha security exchange in order to trade on the exchange.23 Furthermore, the ExchangeAct authorizes the SEC to require issuers to provide financial information uponregistration" and in annual and quarterly reports.25 The SEC has broad authority toprescribe the content of these reports and the accounting methods to be used incompleting them.26

15. Securities Act of 1933, 15 U.S.C. §§ 77a-77aa (1994).16. See Louis Loss & JOEL SELIGMAN, SECURITIES REGULATIONS § I-F (3d ed. 2001).17. Id.18. Id. § I-G-3.19. 15 U.S.C. § 77(e) (1994) (original version amended by Amendments to the Securities Act of 1933, Pub.

L. 100-181, § 201, 101 Stat. 1252 (1987) (substituting "Securities and Exchange Commission" for "Federal TradeCommission")).

20. 15 U.S.C. § 77(k).21. Securities Exchange Act of 1934, 15 U.S.C. §§ 78(a)-(l/) (1994).22. Id. § 78(d).23. Id. § 78(l).24. Id.25. Id. § 78(m).26. See id.

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THE SARBANES-OXLEY ACT

Historically, the SEC has delegated its authority to establish accounting methodsto private regulatory boards.27 The SEC has largely adopted the accounting methodsestablished by the Financial Accounting Standards Board (FASB), 28 the primarystandard setter for the accounting profession. 29 The standards established by FASBare referred to as Generally Accepted Accounting Principles (GAAP).3 °

C. The Role ofAccounting and the Independent Public AuditorBoth the Securities Act and the Exchange Act aim to provide the investing public

with accurate information about securities. 3' Financial accounting is the way thatthis information is transmitted to the public. 32 As explained by the SEC, "accurateand reliable reporting lies at the heart of our disclosure-based system, and is criticalto the integrity of the U.S. securities market., 33 Members of the accountingprofession have been described as "the referees and scorekeepers for Americanbusiness."34

Thus, pursuant to the securities laws, the SEC requires issuers of securities toregularly provide financial statements, many of which must be certified by anindependent auditor. 35 The auditor plays a critical role in insuring financialinformation is accurate.36 Auditors have been characterized as "the 'gatekeepers' to

27. See MATTHEW BENDER, ATTORNEY'S HANDBOOK OF ACCOUNTING, AUDITING& FINANCIAL PLANNING§ 1.02 (2002).

28. Id. § 1.02[6].29. Id. § 1.02[3].30. See id. §§ 1.02[l], 1.02[3].31. Revision of Commission's Auditor Independence Rules, 65 Fed. Reg. 76,008, 76,008 (Dec. 5, 2000)

(codified at 17 C.F.R. pts. 210, 240).32. BENDER, supra note 27 § 1.01.33. SEC, Standards Related to Listed Company Audit Committees, 2003 SEC LEXIS 38 (Jan. 8, 2003).34. Albert B. Crenshaw & Brett D. Fromsom, A Conflictfor CPAs' Firms'lndependence Questioned as Ties

to Clients Grow, WASH. POST, Mar. 29, 1998, at HI.35. Revision of Commission's Auditor Independence Rules, 65 Fed. Reg. at 76,012 n.34:

For example, Items 25 and 26 of Schedule A to the Securities Act, 15 U.S.C. 77aa(25) and (26),and Section 17(e) of the Exchange Act, 15 U.S.C. 78q, expressly require that financialstatements be audited by independent public or certified accountants. Sections 12(b)(I)(J) and(K) and 13(a)(2) of the Exchange Act, 15 U.S.C. 781 and 78m, Sections 5(b)(H) and (1),10(a)(1)(G), and 14 of the Public Utility Holding Company Act of 1935 ("PUHCA"), 15 U.S.C.79e(b), 79j, and 79n, Sections 8(b)(5) and 30(e) and (g) of the Investment Company Act of 1940("ICA"), 15 U.S.C. 80a-8 and 80a-29, and Section 203(c)( 1 )(D) of the Investment Advisers Actof 1940 ("Advisers Act"), 15 U.S.C. 80b-3(c)(1), authorize the Commission to require the filingof financial statements that have been audited by independent accountants. Under this authority,the Commission has required that certain financial statements be audited by independentaccountants. See, e.g., Article 3 of Regulation S-X, 17 C.F.R. 210.3-01, et seq. In addition,public companies must have their quarterly reports reviewed by independent accountants. Article10 of Regulation S-X, 17 C.F.R. 210.10-01(d) and Item 310(b) of Regulation S-B, 17 C.F.R.228.310(b). The federal securities laws also grant the Commission the authority to define theterm "independent." Section 19(a) of the Securities Act, 15 U.S.C. 77s(a), Section 3(b) of theExchange Act, 15 U.S.C. 78c(b), Section 20(a) of PUHCA, 15 U.S.C. 79t(a), and Section 38(a)of the ICA, 15 U.S.C. § 80a-37(a), grant the Commission the authority to define accounting,technical, and trade terms used in each Act. Section 17 of the Exchange Act, 15 U.S.C. 78q, andSection 31 of the Investment Company Act, 15 U.S.C. 80a-30, grant the Commission authorityto prescribe accounting principles to be used in the preparation of financial statements required.

Id.36. Id. at 76,008.

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the public securities markets."37 Audits are to be performed in accordance withGenerally Accepted Auditing Standards (GAAS).38 Although authorized to modifyand supplement auditing principles, the SEC has largely adopted the principles andstandards established by the American Institute of Certified Public Accountants(AICPA), an organization consisting mostly of certified public accountants(CPAs).3 9

D. Changes in the Accounting Profession

Recently, the accounting industry has undergone significant change." Theaccounting profession has expanded into a global business.4 ' Moreover, manyaccounting firms merged, and consequently the majority of independent audits arenow performed by the five largest accounting firms, the "Big Five. 42

One result of the consolidation of accounting firms and global expansion is theperformance of non-traditional accounting services by accounting firms. 43 Mostmajor accounting firms now offer a wide variety of non-audit services. 4 Theseinclude not only traditional accounting services such as tax services, but alsointernal audits, financial consulting, actuarial services, marketing services, andcertain legal services. 4

For the Big Five, revenue from non-audit services now makes up half of theirtotal revenue.46 Thus, non-audit service revenues are important, if not crucial, to thefinancial success of accounting firms. This reliance on non-audit services draws intoquestion the true independence of the auditor. A common fear is that audit clientsuse their control over non-audit services to influence the auditing firm's opinion ontheir financial statements.48

37. Id. at 76,011.38. See BENDER, supra note 27 § 12.01.39. Id. See generally AICPA, at http://www.aicpa.org (last visited July 21, 2003) (providing text of the

GAAS and Auditors Code of Professional Conduct).40. Revision of Commission's Auditor Independence Rules, 65 Fed. Reg. at 76,013.41. Id.42. Id. See generally Reed Abelson, Two of the Big Six in Accounting Plan to Form New No. 1, N.Y. TIMES,

Sept. 19, 1997, at Al (noting that the "Big Five" referred to Arthur Anderson, L.L.P.; PricewaterhouseCoopers,L.LP.; Ernst & Young, L.L.P.; KPMG, Peat Marwick, L.L.P.; and Deloitte & Touche, L.L.P.).

43. Revision of Commission's Auditor Independence Rules, 65 Fed. Reg. at 76,013.44. Id.45. The remaining "Big Four" offer a wide variety of accounting services on their websites. See generally

KPMG, Peat Marwick, at http://www.kpmg.comlservices/ (last visited July 21, 2003); Deloitte & Touche, athttp://www.deloitte.com/dtt/home/0%2C2334%2Csid%25253DI000%2C00.html (last visited July 21, 2003);PricewaterhouseCoopers, at http://www.pwcglobal.com/us/eng/aboutlsvcs/index.html (last visited July 21, 2003);Ernst & Young, at http://www.ey.com/global/content.nsf/International/services (last visited July 21, 2003).

46. Revision of Commission's Auditor Independence Rules, 65 Fed. Reg. at 76,012.47. Id. at 76,010.48. Id.

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Summer,,201fi , L.,I 485

E. Changes in the Financial Market LandscapeChanges in the operation of financial markets have also affected accounting

practices.49 In the current market, the price of a company's stock is heavilyinfluenced by the company's ability to meet the growth and earnings projections offinancial analysts.50 Thus, public companies are under extreme pressure to maintainor improve stock prices by meeting earnings estimates." This pressure leadscompanies to make accounting decisions based on the results the decision will haveon earnings-in effect, to manage their earnings. 2 The net result can be "creative"accounting practices that inaccurately represent a company's financial situation.53

There are a handful of accounting methods that are often used to manipulatestatements of a company's earnings. The most common area of abuse involves therecognition of revenue. 4 In general, revenue should be recognized in the period inwhich it is realized and earned. 5 Improper revenue recognition occurs when acompany recognizes revenue in a period before it is truly earned or realized, or whena company falsely recognizes revenue. 6 For example, Enron apparently manipulatedits earnings by inaccurately recognizing revenue on energy trades.5 When thecompany traded electricity or gas, it recorded the entire amount of the transactionas revenue.58 A more accurate accounting would have recorded the profit or loss onthe transaction as revenue, treating it like a brokerage fee or commission. 9

Another common area of manipulation involves losses.6" Companies use losscontingencies, allowances, and reserves to smooth income from year to year.6 Theseso-called "cookie jar reserves" allow a company to overestimate or prematurelyrecord a loss or expense in order to reduce income in an earlier period.62 WorldComused this type of reserve by overestimating expected expenses and then laterreversing them to improve reported earnings.63

The capitalization of expenses provides another opportunity to manipulateearnings.' Generally, when a cost incurred is related to a benefit that is expected tobe limited to the current accounting period, the entire cost should be expensed in

49. See id. at 76,013.50. Id.51. Id.52. Manuel A. Rodriguez, Comment, The Numbers Game: Manipulation of Financial Reporting byCorporations and Their Executives, 10 U. MIAMI BuS. L. REV. 451, 459 (2002).53. Id.54. David B. Harms et al., Behind the Numbers: A Review of Six Accounting Problem Areas, in WHATEVERY LAWYER NEEDS TO KNOW ABOUT ACCOUNTING-OR ELSE 579, 584 (John White, chair, 2002).55. Id.56. Id.57. Gretchen Morgenson, Enron 's Collapse: News Analysis; A Bubble No One Wanted to Pop, N.Y. TIMES,

Jan. 14, 2002, at Al.58. Id.59. Id.60. Harms, supra note 54, at 610.61. Id.62. Rodriguez, supra note 52, at 461.63. David Ward, Reserves Being Misused to Boost Earnings; Accounting: WorldCom Employedthe "CookieJar" Practice to Help It Hide $3.9 Billion in Expenses, Experts Say, L.A. TIMES, Aug. 12, 2002, pt. 3, at 3.64. Harms, supra note 54, at 624.

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that period.65 In contrast, a cost that is expected to provide a benefit in future periodsshould be capitalized.66 The underlying principle is that the cost should be spreadout over the periods when the benefit occurs.67 Whether a benefit occurs in thecurrent period, however, is not always clear.68 This ambiguity may be used tounderstate expenses, and likewise overstate earnings, by improperly capitalizingexpenses.69 WorldCom was charged with overstating its income in 2001 by $3.8billion using this technique.7°

These and many other accounting methods are used by companies to manipulateearnings. Caught in the middle of these accounting manipulations are the auditorswho are pressured to go along with the companies' estimates and decisions. 71 Asformer SEC chairman Arthur Levitt explains, "Companies can't afford to disappointWall Street earnings expectations, so they are tempted to push their earnings, evento the point of deception. And aggressive or sometimes creative accounting is oftenoverlooked by auditors preoccupied with the desire to preserve lucrative auditingand consulting contracts. 72

F. Accounting Issues under Scrutiny

The many roles played by accounting firms and the increased pressure on auditorsto rubber stamp creative accounting practices raised serious questions about theintegrity of the financial disclosure and auditing system in the United States.73 In1996, Representative John Dingell requested a review of the accounting professionby the General Accounting Office (GAO).74 The GAO produced a comprehensivereport that addressed five areas related to auditing: (1) auditor independence, (2)auditor's responsibilities for fraud and internal controls, (3) audit quality, (4) theaccounting and auditing standard-setting process and the effectiveness of financialreporting, and (5) the role of the auditor in the further enhancement of financialreporting. 75 The report brought to the forefront questions about the reliability ofaudits and the financial reporting system.76

In 1997, in response to pressure from Congress, investors, and many others, theSEC announced that the AICPA was creating an Independence Standards Board

65. Id.66. Id.67. Id.68. Id.69. Id. at 648.70. James S. Granelli et al., The WorldCom Scandal; What Went Wrong? SEC Targets Top Execs; Errors

Shock Analysts, L.A. TIMES, June 27, 2002, pt. 3, at I (explaining that ordinary costs for connecting customers toWorldCom's network were recorded as capitalized expenses on the company's balance sheet rather than expenseson the profit and loss statement).

71. Id. See also Revision of the Commission's Auditor Independence Requirements 65 Fed. Reg. 76,008,76,013 (Dec. 5, 2000) (codified at 17 C.F.R. pts. 210, 240).

72. Arthur Levitt, Who Audits the Auditors?, WASH. POST, Jan. 17, 2002, at A29.73. See supra note 71.74. ACCOUNTING AND INFORMATION MANAGEMENT DIVISION, U.S. GENERAL ACCOUNTING OFFICE, THE

ACCOUNTING PROFESSION, MAJOR ISSUES: PROGRESS AND CONCERNS 2 (1996).75. Id. at 4, 22.76. Id.

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(ISB) to establish independence standards for auditors.77 However, in 2000, in anunusual move, the SEC bypassed the AICPA and the ISB and proposed a numberof its own rules regarding the independence of auditors.78 The proposed rulesdetailed financial, employment, and business relationships that impair auditorindependence.79 The proposed rules also banned ten types of non-audit services.80

In December 2000, the SEC enacted a watered-down version of these rules.8 '

111. RECENT DEVELOPMENTS

A. Enron, WorldCom, and Other Corporate ScandalsIn the midst of discussions about auditor independence came the Enron scandal.

On December 2, 2001, Enron filed the largest bankruptcy petition in U.S. history.82

Enron allegedly overstated reported profits by almost $600 million83 and managedto hide more than $1 billion in debt in partnerships." Implicated in the Enronscandal was the Big Five firm Arthur Anderson, which had conducted Enron'saudits.85 Enron, however, was just the beginning, as other accounting scandals wereexposed in the months after Enron's bankruptcy announcement.

Late in June 2002, WorldCom announced that it had misstated $3.8 billion in itsfinancial statements.86 The SEC quickly filed civil fraud charges against thecompany. 87 Shortly thereafter, the company filed for bankruptcy protection.88 Thecompany went on to make additional restatements totaling more than $9 billion.89

These and other accounting scandals left many doubting the integrity of theauditing system. 90 In response, Congress drafted legislation to address the apparentproblems in the corporate accounting arena.9'

77. News Release, SEC and AICPA Announce the Creation of a New Independence Standards Board (May21, 1997), available at http://www.sec.gov/news/press/pressarchive/1997/97-4l .txt.

78. Revision of Commission's Auditor Independence Rules, 65 Fed. Reg. 43,148 (July 12, 2000).79. Id. at 43,148 & 43,190-92.80. Id. at 43,148 & 41,192. The proposed rules prohibited ten non-audit services: bookkeeping services,

financial information systems design and implementation, appraisal or valuation services, actuarial services, internalaudit outsourcing, management functions, human resources, broker-dealer, investment advisor or investmentbanking services, legal services, and expert services. Id.

81. Revision of Commission's Auditor Independence Rules, 65 Fed. Reg. 76,008, 76,043 (Dec. 5, 2000)(codified at 17 C.F.R. pts. 210, 240) (revising final rules to prohibit nine non-audit services and adding severalexceptions to the prohibitions).

82. Peter Behr, Ailing Enron Files for Chapter II Bankruptcy Protection, WASH. POST, Dec. 3,2001, at A7.83. Id.84. Bloomberg News, Enron Shareholders' Move Against Banks Is Rebuffed by Judge, N.Y. TIMES, Feb.

28, 2003, at C5.85. Floyd Norris, Enron 's Many Strands: The Auditors; Memo Says Auditors Sought, but Didn't Get, Crucial

Data, N.Y. TIMES, Feb. 7, 2002, at C7.86. WorldCom announced the financial misstatements on June 21, 2002. Seth Schiesel & Simon Romero,

WorldCom Strikes a Deal with SEC, N.Y. TIMES, Nov. 27, 2002, at Cl.87. Id.88. Id.89. Id.90. See, e.g., The Watchdog Doesn't Bark, WASH. POST, Jan. 30, 2002, at C16.91. See Carlino, supra note 3.

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B. Legislation in Response to Enron and Other ScandalsOn February 14, 2002, shortly after Enron announced bankruptcy, Representative

Michael Oxley introduced House Bill 3763, titled the Corporate and AuditingAccountability, Responsibility, and Transparency Act of 2002.92 The bill addressedauditor independence and financial disclosures.93 House Bill 3763 passed the House,with a few minor amendments, on April 24, 2002, by a vote of 334 to 90.94

On June 25, 2002, Senator Paul Sarbanes introduced Senate Bill 2673.9' The billcontained three separately titled proposals: The Public Company AccountingReform and Investor Protection Act of 2002, the White-Collar Crime PenaltyEnhancement Act of 2002, and the Corporate and Criminal Fraud AccountabilityAct of 2002.96 On July 15, 2002, the Senate passed House Bill 3763 withamendments from Senate Bill 2673.9' The Senate included the provisions regardingcriminal fraud98 and white-collar crime penalty enhancements. 99 A conferencecommittee worked out the details of the bill and on July 25, 2002, both chambersoverwhelmingly passed the Sarbanes-Oxley Act of 2002.100 On July 30, 2002,President Bush signed the legislation, announcing it to be "the most far reachingreforms of American business practices since the time of Franklin DelanoRoosevelt."'°!

IV. THE SARBANES-OXLEY ACT OF 2002The Sarbanes-Oxley Act addresses the failings of corporate accounting from three

starting points. First, the Act establishes federal regulation of the accountingindustry by creating the PCAOB. °2 Second, the Act prescribes specific rules andprocedures for accounting firms and auditors. 03 And finally, the Act prescribes newrules and procedures for issuers."

A. The Public Company Accounting Oversight BoardTitle I of the Sarbanes-Oxley Act establishes the PCAOB.'05 The PCAOB is

responsible for registering public accounting firms that audit publicly traded

92. See Union Calendar No. 247, H.R. 3763, 107th Congress (2d sess.), available at http://www.house.gov/rules/h3763_rh.pdf (last visited July 21, 2003).

93. Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002, H.R. 3763, 107thCong. (2002).

94. Union Calendar No. 247, H.R. 3763, supra note 92.95. Calendar No. 442, S. 2673, 107th Congress (2d sess.), available at http://www.energymarketers.com/

documents/S2673.pdf (last visited July 21, 2003).96. Public Company Accounting Reform and Investor Protection Act of 2002, S. 2763, 107th Cong. (2002).97. Calendar No. 442, S. 2673, supra note 95.98. H.R. 3763 §§ 801-807.99. H.R. 3763 §§ 901-911.

100. Union Calendar No. 247, H.R. 3763, supra note 92.101. President George W. Bush, Remarks at the Signing of the Corporate Accountability Bill (July 30, 2002),

in FED. NEWS SERV., July 30, 2002.102. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 101(a), 116 Stat. 745, 750 (codified at 15 U.S.C.

§ 721 I).103. Id. §§ 201-209.104. Id. §§ 301-409.105. Id. § 101(a).

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companies.' °6 The Act requires the registration of any public accounting firminvolved in the preparation or issue of an audit report for an issuer. °7

The PCAOB is directed to set auditing, quality control, and independencestandards that will govern registered public accounting firms.108 The Act providesthat the PCAOB shall adopt accounting standards requiring each registered publicfirm to prepare and maintain audit work papers for seven years, require that a"concurring or second partner review and approv[e]" audit reports, and describe theauditor's testing of the issuer's internal control structure in the audit report."

The PCAOB is also given authority to conduct inspections of registeredaccounting firms"0 to identify any "act, practice or omission" that may be inviolation of the Sarbanes-Oxley Act, the rules of the PCAOB, the rules of the SEC,the firm's own quality control procedures, or professional standards."' Accountingfirms that regularly audit more than 100 issuers are to be inspected every year." 2

Firms auditing less than 100 issuers are to be inspected no less frequently than everythree years." 3

Furthermore, the PCAOB is authorized to conduct investigations and disciplinaryproceedings and impose sanctions on registered public accounting firms." 4 TheSarbanes-Oxley Act authorizes the PCAOB to impose sanctions that includesuspension or revocation of registration, limitations on a firm's activities, civilpenalties, additional professional education or training, and any other sanctionincluded in the PCAOB's rules. "'

The Sarbanes-Oxley Act gives the SEC "oversight and enforcement authorityover the [PCAOB]."" 6 The PCAOB is to be funded through registration feescollected from accounting firms and "accounting support fees" collected fromissuers.'

B. Analysis of the PCAOB

1. The Accounting Industry Is No Longer Self-Regulated

Undoubtedly the accounting industry is forever changed by the creation of thePCAOB. Prior to the passage of the Sarbanes-Oxley Act, accountants andaccounting firms were essentially self-regulated. The AICPA and FASB,organizations largely made up of accountants, established the majority of the rulesgoverning the accounting industry. The Act fundamentally altered the regulatory

106. Id. § 101(c)(1).107. Id. § 102(a).108. Id. § 101(c)(2).109. Id. § 103(a)(2)(A).110. Id. § 101(c)(3).111. Id. § 104(c).112. Id. § 104(b).113. Id.114. Id. § 101(c)(4).115. Id. § 105(b)(3).116. Id. § 107(a).117. Id. § 109.

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NEW MEXICO LA W REVIEW

scheme for auditing by requiring every public accounting firm to register with thePCAOB and comply with the PCAOB's auditing standards.

Furthermore, the creation of the PCAOB establishes the SEC's authority todiscipline the accounting profession. The SEC previously proposed toadministratively create a similar board, but questions existed regarding the SEC'sauthority to do so." 8 The Sarbanes-Oxley Act clearly establishes that the SEC,through the PCAOB, may regulate the accounting industry. Thus, with the passageof the Act, the accounting industry becomes a federally regulated industry.

2. The Accounting Industry's Influence Continues

a. The PCAOB May Adopt Rules Established by Accounting OrganizationsDespite this new regulatory scheme, accountants may continue to exert significant

influence over the regulation of the accounting industry. The Sarbanes-Oxley Actauthorizes the PCAOB to adopt auditing standards proposed by professional groupsof accountants such as the AICPA or FASB." 9 Thus, although the PCAOB isrequired to satisfy the specific auditing provisions set out in the Sarbanes-Oxley Act,it may do so by adopting rules established by the AICPA or other professionalgroups. Drafting completely new auditing rules is a difficult and daunting task, andthe PCAOB may opt to rely on the accounting industry to write these rules. In thisway, the accounting industry may retain a substantial amount of influence over itsown regulators.

b. The SEC and PCAOB Operate Under Intense Political PressureSimilarly, the members of the PCAOB are exposed to political pressure from the

accounting industry. 2 ° Section 101(e) of the Sarbanes-Oxley Act details themembership requirements for the PCAOB. The PCAOB is to consist of fivemembers with "an understanding of the responsibilities for and nature of thefinancial disclosures required of issuers under the securities laws and the obligationsof accountants with respect to the preparation and issuance of audit reports withrespect to such disclosures."' 2 ' However, the Act allows no more than two membersto be or have been CPAs.'22 Although this limitation on CPAs undoubtedly reducesthe PCAOB members' personal ties to the accounting industry, the accountingindustry remains a powerful lobbying force and can be expected to pressure thePCAOB.

118. Senate, House Conferees Agree on Reform Measure, FED. SEC. L. REP. Issue No. 2038, at 2035 (July26, 2002).

119. Sarbanes-Oxley Act § 103(a)(3).120. The accounting industry has considerable political power. The industry has avoided regulation thus far

by aggressively lobbying legislators and making political contributions. The accounting industry launched a multi-million dollar lobbying campaign to prevent Congress from passing the accounting reforms in the Act. See JackieSpinner, Audit Firms Rev Up Lobbying Push, WASH. POST, Mar. 13, 2002, at El; Jim VanderHei & David S.Hilzenrath, Hill Leaders Agree on Corporate Curbs; Attack on Fraud Includes Auditing Control and Jail Terms;Markets Soar, WASH. POST, July 25, 2002, at Al.

121. Sarbanes-Oxley Act § 101(e)(l).122. Id. § 101(e)(2).

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The SEC's difficulty in appointing members to the PCAOB demonstrates howdifficult and politically complicated the PCAOB's job will be. According to theSarbanes-Oxley Act, PCAOB members serve for a term of five years. 23

Furthermore, members must serve on a full-time basis and may not have any otheremployment or business activity during their term. 24 The exclusivity and timerequirements alone limit the number of individuals that are able, let alone willing,to serve on the PCAOB.

From this pool of individuals the SEC must then find members that are politicallyacceptable. This has proven to be difficult. 125 For example, SEC Chairman HarveyPitt initially attempted to appoint John Biggs to head the PCAOB. 26 Biggs had beencritical of the accounting profession and publicly supported increasing accountingoversight. 27 However, Pitt was pressured by Republican lawmakers and theaccounting industry to forgo this candidate, who was seen as being too tough on theaccounting industry. 28

The SEC then appointed William Webster to head the PCAOB, over the bitterobjections of the Democratic commissioners.129 Pitt and the other Republicancommissioners faced accusations that they "had succumbed to the pressures fromthe accounting industry"'30 because Webster lacked the experience and knowledgeneeded to oversee the accounting industry.'3 ' Webster's appointment exploded incontroversy when it was revealed that Webster headed the audit committee of aWashington company with significant accounting problems. 32 After less than amonth as head of the PCAOB, Webster resigned. 33

Also implicated in the controversy was Chairman Pitt. 134 He tendered his ownresignation after it was revealed that Webster had informed him of the auditcommittee issues, but Pitt had failed to deliver this information to the othercommissioners. 3 On February 14, 2003, the Senate confirmed the nomination ofWilliam H. Donaldson as the new chairman of the SEC. 36 Donaldson indicated that

123. Id. § 101(e)(5).124. Id. § 101(e)(3).125. Stephen Labaton, SEC Chief Hedges on Accounting Regulator, N.Y. TIMES, Oct. 4, 2002, at CI; Paul

Krugman, Editorial, Revenge of the Accountants, N.Y. TIMEs, Oct. 10, 2002, at A38; Paul Krugman, Editorial, FoolMe Once, N.Y. TIMES, Oct. 8, 2002, at A3 1; David S. Hilzenrath, Webster to Lead Auditing Oversight; SEC Votes3-2 over Democratic Objections, WASH. POST, Oct. 26, 2002, at El; David S. Hilzenrath & Kathleen Day, WebsterLeaving Audit Job; Resignation May Hinder Cleanup, WASH. POST, Nov. 13, 2002, at AI.

126. Labaton, supra note 125; Krugman, Revenge of the Accountants, supra note 125; Krugman, Fool MeOnce, supra note 125.



129. Hilzenrath, supra note 125.130. Id.131. Id.132. While Webster was head of the audit committee, the company repeatedly failed to file financial reports

on time and fired an outside auditor after the auditor warned the company that it "lacked the accounting controlsnecessary to produce reliable financial reports." Id.

133. Id.134. Id.135. Id.136. Donaldson Confirmed for SEC, WASH. POST, Feb. 14, 2003, at E2.

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his first priority would be finding a chair for the PCAOB.'37 As of this writing,however, the board remains leaderless.

c. The SEC and PCAOB Have Insufficient ResourcesOnce the PCAOB is complete, it has a number of pressing tasks to complete. It

must establish the auditing rules that will govern the industry, register publicaccounting firms, and then begin inspecting these firms. All this must beaccomplished using the fees collected from issuers and accounting firms.138

Although overseen by the SEC, the PCAOB will be hard pressed to obtain muchassistance from the resource-strapped SEC. Suffering from budget constraints, theSEC has indicated it will not be able to handle the record number of enforcementactions arising out of the corporate scandals of 2002.139 According to a GAO report,the SEC has insufficient financial resources and "has been faced with an everincreasing workload and ongoing human capital challenges."'" Although Congresshas drafted spending legislation that significantly increases the SEC's funding, theSEC has not, as of this writing, received additional funding. 4 Clearly, the SEC doesnot have sufficient resources to do its own job. This makes it unlikely that the SECwill be able to help jumpstart the PCAOB.

3. Accounting Reform Depends on the Success of the PCAOBClearly the success of the Sarbanes-Oxley Act depends largely on the success of

the PCAOB. The PCAOB is responsible for implementing key provisions of the Act.The PCAOB is responsible for inspecting accounting firms to ensure the Act isbeing properly followed. The PCAOB is also responsible for investigating anddisciplining accounting firms that are not in compliance. With the PCAOB off to arocky start, it faces numerous obstacles.

C. New Rules and Procedures for AuditorsThe Sarbanes-Oxley Act also attempts to improve corporate accounting by

addressing issues regarding auditors. The Act establishes rules regarding theindependence of auditors.'42 It also dictates procedures that auditors must follow inthe performance of audits. 43

137. Kathleen Day, Senate Committee Backs SEC Nominee, Donaldson Could Be at Work Next Week, WASH.POST, Feb. 12, 2003, at El.

138. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 109, 116 Stat. 745, 769 (codified at 15 U.S.C. §7219).

139. SEC Seeks Greater Resources for Enforcement Cases: Regulation Backed by a Study, the Agency WillAsk Congress for a Bigger 2003 Budget to Handle Post-Enron Demand, L.A. TIMES, Mar. 6, 2002, pt. 3, at 6.

140. U.S. GENERAL ACCOUNTINGOFFICE, SEC OPERATIONS; INCREASED WORKLOADCREATES CHALLENGES,GAO-02-302, at 33 (Mar. 2002), available at http://www.gao.gov/new.items/d02302.pdf.

141. Dan Morgan, GOP Wraps Up Spending Package; Despite Snags in $397.4 Billion Plan, RepublicansSignal Readiness to Vote, WASH. POST, Feb. 13, 2003, at Al.

142. Sarbanes-Oxley Act §§ 201-209.143. Id.

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1. Auditor IndependenceThe Sarbanes-Oxley Act addresses auditor independence in a number of ways.'"

Section 201 addresses the potential conflict of interest that arises when anaccounting firm audits a company and also performs non-audit services for thecompany. Section 201 prohibits the auditing firm from performing a number of non-audit services.'45 The Act specifically prohibits an auditing firm from performingbookkeeping services, financial information systems design or implementation,appraisal or valuation services, actuarial services, internal audit outsourcingservices, management functions, investment banking services, legal services, andany other services the PCAOB decides to prohibit."4 The Act does, however, allowthe issuer's audit committee to approve non-audit services that are not specificallyprohibited. '47

The Sarbanes-Oxley Act also addresses several other potential conflicts ofinterest between auditors and issuers. Section 203 requires the rotation of auditorsby making it

unlawful for a registered public accounting firm to provide audit services to anissuer if the lead (or coordinating) audit partner (having primary responsibilityfor the audit), or the audit partner responsible for reviewing the audit hasperformed audit services for that issuer in each of the 5 previous fiscal years ofthat issuer.'48

In other words, if the lead audit partner has audited a client for five consecutiveyears, a new audit partner must perform the audit services on the sixth year.

Similarly, Section 206 prohibits accounting firms from auditing companies whoseofficers are former employees."' Specifically, Section 206 forbids the audit of anissuer if the

chief executive officer, controller, chief financial officer, chief accountingofficer, or any person serving in an equivalent position, was employed by thatregistered independent public accounting firm and participated in any capacityin the audit of that issuer during the 1-year period preceding the date of theinitiation of the audit. 50

As the SEC explains, when former employees of accounting firms assume positionswith the firm's audit clients, they may be able to "influence the content of the auditclient's accounting records and financial statements on one hand, and the conductof the audit on the other."' 51 Section 206 addresses this potential conflict of interest.

144. Id.145. Id. § 201(a).146. Id.147. Id. § 201(h).148. Id. § 203.149. Id. § 206.150. Id.151. Revision of the Commission's Auditor Independence Requirements, 65 Fed. Reg. 76,008, 76,041 (Dec.

5, 2000) (codified at 17 C.F.R. pts. 210, 240).

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2. Audit ProcedureThe Sarbanes-Oxley Act also dictates the contents of an auditor's report to the

audit committee.'52 Under Section 204, the auditor must report

(1) all critical accounting policies and practices to be used; (2) all alternativetreatments of financial information within generally accepted accountingprinciples that have been discussed with management officials of the issuer,ramification of the use of such alternative disclosures and treatments, and thetreatment preferred by the registered accounting firm; and (3) other materialwritten communication between the registered public accounting firm and themanagement of the issuer.1 3

Furthermore, pursuant to Section 401, financial reports must disclose "all materialcorrecting adjustments that have been identified by a registered public accountingfirm in accordance with [GAAP] and the rules and regulations of theCommission. '54

Finally, Section 802 of the Sarbanes-Oxley Act requires "any accountant whoconducts an audit of an issuer" to "maintain all audit or review workpapers for aperiod of 5 years from the end of the fiscal period in which the audit or review wasconcluded.""' An accountant that "knowingly and willfully" violates this provisionfaces fines and up to ten years imprisonment, or both. 5 6

D. Analysis of New Rules and Procedures For Auditors

1. Auditor IndependenceWhen the Sarbanes-Oxley Act is compared to existing auditor independence

rules, it is unclear whether the Act will really improve information or protectinvestors as it claims. At first blush, the prohibitions on non-audit services inSection 201 would appear to improve auditor independence by removing thepossibility that the objectivity of an auditor will be influenced by potential fees fromnon-audit services. However, Section 201 does not accomplish as much as onemight believe. The section does prohibit audit firms from performing many non-audit services,'57 but the nine prohibited services were already prohibited by theSEC.'58 Thus, the Act's provisions do not improve existing independence rules inthis regard. Furthermore, the audit committee of the issuer is authorized to allow anaccounting firm to perform any non-audit services that are not specificallyprohibited."' There remains a significant opportunity for the objectivity of auditorsto be tainted.

152. Sarbanes-Oxley Act § 204.153. Id.154. Id. § 401(a).155. Id. § 802(a).156. Id.157. Id. § 201.158. See 17 C.F.R. § 210.2-01(c)(4). See supra part H.F.159. Sarbanes-Oxley Act § 201.

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Moreover, Section 201 allows an accounting firm to provide tax services for anaudit client with the approval of the audit committee."6 Historically, accountingfirms have been allowed to provide tax services to their audit clients.' 6' There hasbeen considerable debate over whether an auditor's independence is impaired byperforming tax services for an audit client. 62 In the final rules, issued pursuant tothe Sarbanes-Oxley Act, the SEC reiterated "its long-standing position that anaccounting firm can provide tax services without impairing the firm'sindependence.'63

The accounting industry strongly opposed a prohibition on tax services becausethese services are a profitable business."' 4 Because they are so valuable toaccounting firms, there remains a logical and compelling argument that accountingfirms are not independent when they perform both audit and tax services. 165 In anattempt to deal with this obvious conflict, the SEC imposed an additionalrequirement that the issuer disclose "the amount of fees paid to the accounting firmfor tax services."'

166

The partner rotation requirements of Section 203 are a valuable addition toauditor independence rules. Section 203 makes mandatory a practice that manyaccounting firms have used as part of their quality control programs. 16 7 Rotation ofpartners allows an issuer's financial statements to be viewed with fresh eyes.'68

The SEC's rules, pursuant to Section 203, go still further to improve auditorindependence. Section 203 only prohibits a partner from performing audit servicesif the partner has performed the services "in each of the five previous fiscalyears."' 169 The SEC could have interpreted this to mean that after not performing theservices for one year the partner could return. The SEC chose, however, to imposea five-year "time out" period for lead and concurring partners. 70 Thus, a partnermay only perform audit services for an issuer for five years and must then wait a fullfive years before returning to that issuer.

Furthermore, the SEC extended the partner rotation requirements to "auditpartners," members of the "audit engagement team who have responsibility fordecision-making on significant auditing, accounting, and reporting matters thataffect the financial statements or who maintain regular contact with managementand the audit committee."'' This is a valuable extension of Section 203 because it

160. Id.161. Strengthening the Commission's Requirements Regarding Auditor Independence, 68 Fed. Reg. 6006,

6017 (Feb. 5, 2003) (to be codified at 17 C.F.R. pts. 210, 240, 249, 274).162. Id. at 6016.163. Id. at 6017.164. Editorial, Downsized Corporate Reform, N.Y. TIMEs, Jan. 23, 2003, at A24.165. Jonathon D. Glater, Enron 's Many Strands: Consulting; Keen Rivalry by Consultants Expected after

Auditor's Shift, N.Y. TIMES, Feb. 22, 2002, at C l ("[Cloncems about conflicts of interest for accountants are likelyto persist because there are some kinds of services that they will continue to sell, like tax advice. That means thereis still the possibility that an auditor's judgment will be swayed by the prospect of nonaudit-related fees.").

166. Strengthening the Commission's Requirements Regarding Auditor Independence, 68 Fed. Reg. at 6017.167. Id.168. Id.169. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 203, 116 Stat. 745, 773 (codified at 15 U.S.C. §

78j-1).170. Strengthening the Commission's Requirements Regarding Auditor Independence, 68 Fed. Reg. at 6018.171. Id. at 6019.

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requires accounting firms to rotate all the auditors that are closely involved, not justthose that hold lead or controlling partner positions.

2. Audit ProceduresSection 206 prohibits an accounting firm from auditing an issuer with a Chief

Executive Officer (CEO), Chief Financial Officer (CFO), controller, or accountingofficer who is a former employee of the accounting firm and participated in theissuer's audit during the previous year,"' which undoubtedly improves existingauditor independence rules.173 Unlike the 2000 auditor independence rule, Section206 "requires a 'cooling off period of one year before a member of the auditengagement team can begin working for the registrant in certain key provisions.""'The SEC had previously considered a "cooling off' period but determined it to"unnecessarily restrict the employment opportunities of former professionals."'75

Section 206 is an important provision, reflecting "the view that the passage of timeis an additional safeguard to reduce the perceived loss of independence for the auditfirm caused by the acceptance of employment by a member of the engagement teamwith an audit client. 176

Unfortunately, Section 206 and the SEC rules create as much ambiguity as theyresolve. The rules expand the scope of Section 206 beyond the four named positionsto individuals in a "financial reporting oversight role,"' 77 a phrase whoseinterpretation is not immediately clear. The rules also provide a number ofexceptions for "unique situations,"'7 another unclear phrase. Furthermore, the ideathat an auditor becomes independent after a year and a day is a fiction. In alllikelihood, the one-year cooling off period really improves only the appearance ofindependence.

The requirements of Section 204 create a mechanism by which auditors arerequired to discuss with the audit committee the accounting practices beingemployed and alternative practices that could be employed.'79 This is a valuablemechanism because auditors must consider the accounting practices being used anddetermine if, in their opinion, another practice is preferable. The auditor must thencommunicate this information to the audit committee. This requirement should forcethe auditor to decide what is the best accounting practice, rather than simplydeciding whether a practice is acceptable.

Section 204 is also valuable because it improves the quality of informationavailable to the audit committee. As Warren Buffett explained, it is the audit

172. Sarbanes-Oxley Act § 206.173. See Strengthening the Commission's Requirements Regarding Auditor Independence, 68 Fed. Reg. at

6007. Compare 17 C.F.R. § 210.2-01(c)(2) (2000) with Strengthening the Commission's Requirements RegardingAuditor Independence, 68 Fed. Reg. at 6044.

174. Strengthening the Commission's Requirements Regarding Auditor Independence, 68 Fed. Reg. at 6007.175. Revision of the Commission's Auditor Independence Requirements, 65 Fed. Reg. 76,008, 76,041 (Dec.

5, 2000) (codified at 17 C.F.R. pts. 210, 240).176. Strengthening the Commission's Requirements Regarding Auditor Independence, 68 Fed. Reg. at 6007.177. Id. at 6008.178. Id. (The rules contain exceptions for conflicts resulting from mergers and acquisitions, conflicts in

certain foreign jurisdictions, and conflicts from emergency or unusual circumstances.).179. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 204, 116 Stat. 745, 773 (codified at 15 U.S.C. §

78j-1).

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committee's job "to hold the auditor's feet to the fire."' 0 The audit committeeshould consider whether the financial statements should have been prepareddifferently than the manner selected by management. 18 ' The requirements of Section204 require auditors to provide the audit committee with the information needed toproperly consider accounting issues.

Section 802 is one of the few provisions of the Sarbanes-Oxley Act that clearlydictates an accountant's behavior and imposes a real penalty for noncompliance.8 2

The possibility of a significant fine and up to ten years in jail'83 should certainlymotivate auditors to carefully maintain their audit and review papers. This provisionseems likely to significantly reduce the willingness of accountants to destroy, alter,or fail to appropriately create documents.

E. New Rules and Procedures for IssuersIn addition to new rules and procedures for auditors, the Sarbanes-Oxley Act also

contains a number of accounting and auditing provisions that apply to issuers. TheAct addresses many accounting and auditing issues by prescribing the issuer'sactions. The Act attempts to protect the integrity of financial statements byprotecting the auditor from the influence of management, requiring management totake personal responsibility for financial reports, and requiring new accountingdisclosures.

1. Separation Between Management and AuditorsSection 301 requires the audit committee of each issuer to be comprised of

independent members of the board of directors. 184 A member is not consideredindependent if (1) the member accepts any consulting, advisory, or othercompensation from the issuer, other than that received in his or her capacity as amember of the committee, the board of directors, or any other committee; or (2) isan affiliated person of the issuer or any subsidiary thereof. 85 This independent auditcommittee is to be "directly responsible for the appointment, compensation, andoversight of the work of any registered public accounting firm employed by thatissuer" performing the company's audit.'86 Section 202 requires the audit committeeto pre-approve all auditing and non-auditing accounting services.8 7 Similarly,Section 301 requires the accounting firms performing the audit to "report directlyto the audit committee"'' 88 rather than to management or the board of directors ingeneral.

180. Strengthening the Commission's Requirements Regarding Auditor Independence, 68 Fed. Reg. at 6027.181. Id.182. Sarbanes-Oxley Act § 802.183. Id.184. Id. § 301 (The definitions indicate that if the company does not have an audit committee the requirements

apply to the entire board of directors.). Id. § 2(a)(3)(B).185. Id. § 301.186. Id.187. Id. § 202.188. Id. § 301.

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Along similar lines, Section 303 makes it unlawful for officers or directors of anissuer to improperly influence the conduct of audits.'89 Officers and directors maynot "take any action to fraudulently influence, coerce, manipulate, or mislead anyindependent public or certified accountant engaged in the performance of an auditof the financial statements of that issuer for the purpose of rendering such financialstatements materially misleading."'90

2. Management's Responsibility for AccountingSection 302 of the Sarbanes-Oxley Act requires CEOs and CFOs to personally

certify the financial statements that are filed by the issuer.' These officers mustcertify that (1) the officer has reviewed the financial report; (2) to the officer'sknowledge the report does not contain or omit any material fact that renders thereport misleading; (3) the financial report "fairly present[s] in all material respectsthe financial condition and results of operations";'92 (4) the signing officers areresponsible for internal controls, have designed and evaluated such controls toensure that the material information is made known to the signing officers, and haveincluded in the report their conclusions regarding the effectiveness of their internalcontrols; (5) the signing officers have disclosed to the auditor any significantdeficiencies in the internal controls and any fraud involving management or otheremployees who have a significant role in internal controls; and (6) the signingofficers have indicated any changes that could "significantly affect internal controlssubsequent to their evaluation."'93 On June 27, 2002, the SEC ordered the CEOs andCFOs .of companies reporting more than $1.2 billion in revenue to certify theirfinancial reports by August 14, 2002.114

In a further attempt to hold chief officers accountable for financial reports,Section 304 provides for CEOs and CFOs to forfeit certain bonuses and profits inthe event an issuer is required to prepare accounting restatements due to "materialnoncompliance of the issuer, as a result of misconduct."'' 9 5 These officers mustforfeit "any bonus or other incentive-based or equity-based compensation" 196 or"any profits realized from the sale of securities"' 9 7 during the twelve-month periodprior to filing the noncompliant financial report.

3. Additional Financial DisclosuresThe Sarbanes-Oxley Act requires a number of new financial disclosures. Section

401 requires the disclosure of "all material correcting adjustments that have been

189. Id. § 303.190. Id.191. Id. § 302.192. Id.193. id. § 302.194. SEC Staff Completes Processing of CEO, CFO Certification, FED. SEC. L. REP. (CCH) No. 2U40, at 2043

(Aug. 28, 2002).195. Sarbanes-Oxley Act § 304(a).196. Id. § 304(a)(1).197. Id. § 304(a)(2).

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identified by a registered public accounting firm."'98 Section 401 also requires theissuer to disclose

all material off-balance sheet transactions, arrangements, obligations (includingcontingent obligations), and other relationships of the issuer with unconsolidatedentities or other persons, that may have a material current or future effect onfinancial condition, changes in financial condition, results of operations,liquidity, capital expenditures, capital resources, or significant components ofrevenue or expenses. 199

Section 401 further requires pro forma financial information to be presented in amanner that is not misleading and adheres to GAAP.2°

Section 403 of the Sarbanes-Oxley Act requires directors, officers, and thoseowning more than ten percent of a company's equity security to file a statement withthe SEC disclosing ownership of the securities."0 ' Section 404 requires annualreports filed with the SEC to state that management is responsible for establishingand maintaining an "adequate internal control structure and procedures for financialreporting" along with an assessment of those structures and procedures.2"2 Section406 requires each issuer to disclose whether the company has adopted a code ofethics for senior financial officers or, if not, to explain why no code has beenadopted. 3 Section 407 requires each issuer to disclose whether or not its auditcommittee contains at least one member who is a financial expert.2 " Likewise, if theaudit committee does not include a financial expert, the issuer must disclose why.20 'The Act also requires issuers to disclose the approval by the audit committee of anon-audit service that is to be performed by the auditing accounting firm.206

198. Id. § 401.199. Id.200. Id.201. Id. § 403.202. Id. § 404.203. Id. § 406.204. Id. § 407.

[A]n audit committee financial expert means a person who has the following attributes: (i) Anunderstanding of generally accepted accounting principles and financial statements; (ii) Theability to assess the general application of such principles in connection with the accounting forestimates, accruals and reserves; (iii) Experience preparing, auditing, analyzing or evaluatingfinancial statements that present a breadth and level of complexity of accounting issues that aregenerally comparable to the breadth and complexity of issues that can reasonably be expectedto be raised by the registrant's financial statements, or experience actively supervising one ormore persons engaged in such activities; (iv) An understanding of internal controls andprocedures for financial reporting; and (v) An understanding of audit committee functions.

Disclosure Required by Sections 406 and 407 of the Sarbanes-Oxley Act of 2002, 68 Fed. Reg. 5110, 5127 (Jan.31, 2003) (to be codified at 17 C.F.R. pts. 228, 229, 249).

205. Sarbanes-Oxley Act § 407.206. Id. § 202.

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F. Analysis of New Rules and Procedures for Issuers

1. Analysis of Separation Between Management and Auditors

The requirement that each issuer have an independent audit committee is avaluable step toward removing potential conflicts of interest between the auditor andthe company being audited. Historically, it has been management that contractedwith accounting firms to perform audits and other accounting services.2"7 Thisbrought into question the objectivity of the auditors, who could find it difficult tocontradict the accounting practices of the management officials responsible foremploying them. Section 301, in conjunction with Section 202, helps create a"forum apart from management where the accountants may discuss theirconcerns."

208

However, the effectiveness of these new rules critically depends on the auditcommittee's understanding of accounting issues. Regrettably, the Sarbanes-OxleyAct does not require that any members of the audit committee be financial experts. °

Thus, there is a possibility that the audit committee will lack the financialsophistication to properly consider questionable accounting practices and to confrontmanagement regarding these practices.

The usefulness of these provisions also depends on the audit committee'sindependence from both the accounting firm and management. These provisions donot address the conflicts of interest that arise because of political and socialdependence among accounting firms and boards of directors. Despite this failing,the audit committee independence requirement gives the SEC some concrete criteriafor evaluating the independence of directors and auditors.Section 303, likewise, provides the SEC with a rule that can be used to punishofficers or directors that inappropriately pressure auditors.2'0 Although similar toexisting rules,2 1' this is an added protection for the auditing process. The value ofthis provision, however, depends on the SEC's willingness and ability to enforce it.

2. Analysis of Management's Personal Responsibility for FinancialStatements

The provisions of the Sarbanes-Oxley Act that bind senior officers to theaccuracy of the issuer's financial statements correctly identify management as asignificant source of accounting problems. On June 27, 2002, the SEC ordered theCEOs and CFOs of companies reporting more than $1.2 billion in revenue to certify

207. Strengthening the Commission's Requirements Regarding Auditor Independence, 68 Fed. Reg. 6006,6022 (Feb. 5, 2003) (to be codified at 17 C.F.R. pts. 210, 240, 249, 274).

208. Id.209. Section 407 requires issuers to disclose whether or not the audit committee contains at least one financial

expert with an understanding of GAAP and experience in auditing. Sarbanes-Oxley Act § 407.210. See id. § 303.211. 17 C.F.R. 240.13b2-1 indicates that "[n]o person shall, directly or indirectly, falsify or cause to be

falsified" accounting records. 17 C.F.R. 240.13b2-2 indicates that directors and officers shall not "[miake or causeto be made any materially false or misleading statements to an accountant" or "[o]mit to state, or cause anotherperson to omit to state, any material fact necessary in order to make statements made, in the light of thecircumstances under which statements were made, not misleading to an accountant...."

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their financial reports by August 14, 2002.2" Section 302 extends the SEC's rule toall public companies.213

According to the SEC, "the overwhelming majority of CEOs and CFOs filedstatements certifying the material accuracy and completeness of their companies'prior disclosure reports. '214 The SEC struggled to wade through the initial 947certifications and to determine what would happen to companies that did notcomply." 5 The certifications required by Section 302 are expected to number about14,000.16 Undoubtedly, the sheer volume of the certifications calls into question theability of the SEC to deal adequately with the certification process.

The provisions of Section 304 offer a more proactive approach to accountingaccuracy. Incentive-based compensation and stock options are a popular form ofexecutive compensation because they are believed to align management's interestswith those of shareholders. 7 However, these forms of compensation also increasemanagement's incentive to use creative accounting to meet earnings expectations.218Section 304 curbs some of that incentive by requiring CEOs and CFOs to forfeitbonuses and profits if the company is required to restate financial information." 9Once again, however, the value of this provision will depend on the ability of theSEC to identify noncompliant reports and require restatements.

3. Implications of Additional Financial DisclosuresThe financial disclosures required by the Sarbanes-Oxley Act will provide

additional information to the investing public. The disclosures in Section 401 are themost beneficial. Requiring issuers to disclose corrections to financial statementsmade during the audit signals to investors that the auditor found a problem in theaccounting and it was corrected. This both motivates the issuer to be careful that theaccounting is done satisfactorily in the first place and provides investors withinformation that may help them consider the company's financial statements morecarefully.

The requirement that off-balance sheet transactions be disclosed likewiseprovides valuable information for investors. Off-balance sheet transactions havebeen used to keep corporate debt off the balance sheet, misrepresenting acorporation's true liability and risk.220 This requirement forces issuers to moreaccurately represent their liabilities to investors.

212. SEC Staff Completes Processing of CEO, CFO Certification, FED. SEC. L. REP. (CCH) No. 2040, at 2043(Aug. 28, 2002).

213. Sarbanes-Oxley Act § 302(a).214. SEC Staff Completes Processing of CEO, CFO Certification, supra note 212.215. Krissah Williams, A Two-Way Race to Certify Financial Statements; Executives Scramble to Complyas Regulators Puzzle Over What to Do About Laggards, WASH. POST, Aug. 13, 2002, at El.216. Id.217. Eric L. Johnson, Waste Not, Want Not: An Analysis of Stock Option Plans, Executive Compensation, andthe Proper Standard of Waste, 26 IOWA J. CORP. L. 145, 148 (2000).218. See supra part H.E.219. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, § 304, 116 Stat. 745, 778 (codified at 15 U.S.C. §

7243).220. Enron used partnerships and other special purpose entities to keep billions of dollars of debt off itsbalance sheet. See Enron Shareholders' Move Against Bank Is Rebuffed by Judge, N.Y. TIMES, Feb. 28, 2003, at

C5.

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NEW MEXICO LA W REVIEW

The other disclosures required by the Act are less valuable, in that they do notprovide accounting information. They may, however, be useful for motivatingissuers to adopt codes of ethics and place financial experts on the audit committeerather than explain why they have not done so.

V. CONCLUSION: THE VALUE OF THE SARBANES-OXLEY ACTDEPENDS ON THE ABILITY OF THE SEC AND PCAOB TO ENFORCE ITThe Sarbanes-Oxley Act approaches accounting reform holistically,2 ' requiring

the federal government, accountants, and issuers to take steps to improve theaccuracy of financial statements. The creation of the PCAOB has the potential toimprove corporate accounting and auditing. The PCAOB is authorized to usepowerful tools, but investors will not benefit unless the board is willing and able toaggressively use those tools.

Unfortunately, the provisions of the Sarbanes-Oxley Act that address accountingfirms and auditors do not offer the same potential for accounting reform. Many ofthe auditor independence rules are little more than a codification of previous SECrules. Furthermore, the Act fails to prohibit auditing firms from performing taxservices for audit clients. Thus, issuers continue to hold a powerful bargaining chipthat may impair the accounting firm's objectivity.

The Sarbanes-Oxley Act makes a timely attempt to address corporate governanceissues that impair the accuracy of financial information. The use of independentaudit committees creates a needed firewall between management and auditors.Holding management accountable for financial information forces officers to takeresponsibility for the accuracy of financial statements. These provisions, combinedwith the increased disclosures, offer some helpful assurances that management is notsimply creating the accounting figures they want the public to see.

On the whole, the Sarbanes-Oxley Act contains a number of provisions that havethe potential to improve corporate accounting practices. However, the legislationleaves to the SEC and the PCAOB the responsibility to implement and enforce thelegislation. Due to political forces and serious resource constraints, it is unclear ifthese agencies will be able to implement the Act. Whether these agencies will beable to effectively implement the Sarbanes-Oxley Act to improve corporateaccounting and protect investors remains to be seen.

221. Many have called the Sarbanes-Oxley Act sloppy legislation, a hodgepodge of provisions. See generallyDavid Futrelle, What Is the Government Doing to Help?, MONEY, Sept. 2002, at 81; Pamela Yip, Oath Brings Angstfor Execs; Corporate Leaders Scramble to Comply with Reform Bill; Lawyers Try to Help Sort Out AccountingDetails as Deadline to Certify Statements Nears, DALLAS MORNING NEWS, Aug. 11, 2002, at IH.

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